When a man is tired of London house prices

‘Since Londoners cannot seem to stop asking, “Is there a bubble?”, I’ve been trying to figure out the answer’

I predicted the UK house price slump of 2007. I was even planning to devote an episode of my BBC2 series to the subject back in 2006, until my producers demanded a different topic. They argued that house prices would assuredly keep rising, so I would seem silly. The replacement theme was “It’s hard to predict the future”; prices duly fell by 15 per cent in real terms.

This triumph should be set in context: I had been forecasting a slump in 2002, 2003, 2004 and 2005. Nevertheless, since Londoners cannot seem to stop discussing the question, “Is there a house price bubble?”, I’ve been trying to figure out the answer, both for Londoners and others.

This isn’t an easy question for economists to answer – bubbles are a matter of psychology, and psychology is not our strong suit. But we can attempt a diagnosis by looking at economic fundamentals. The price of any investment asset should be related to the future income you can derive from that asset, whether it’s the rent you can earn as a landlord, the dividends from corporate shares, or the interest payments on a bond.

A good working definition of a bubble is that the price of an asset has become detached from fundamentals, which means the only way to make money in a bubble is to find a bigger fool to take the thing off your hands.

What are fundamentals telling us? The most straightforward comparison here is of the price of buying a house versus the price of renting one. In the UK, both prices and rents are at high levels relative to income. This is no surprise: everyone knows that the UK has been building too few houses for many years.

But have prices outpaced rents, suggesting a bubble? It seems so. US house prices are at historical norms relative to rents, and German and Japanese prices are unusually cheap to buy rather than rent. Yet in the UK, house prices are one-third above their long-term value relative to rents. And in London, gross rental yields are lower than in other UK regions at a slim 5-ish per cent. Such returns look low, given the costs of being a landlord. Logically, either rents should soar or prices should fall.

Yet London prices have lost touch with London earnings and with the price of houses in London’s commuter belt, and they continue to rise quickly. All this seems unsustainable, and when interest rates finally rise, surely the distressed sales will begin?

But there are three counter-arguments. The first is that housing is different. The second is that London itself is different. The third is that this time around is different.

Let’s dispense with the argument that housing is somehow bubble-proof. Bricks and mortar seem reassuring but there is no law of economics that says money is safe in housing. Real Japanese house prices have almost halved since 1992. Real house prices in the US have soared and slumped and are now cheaper than they were in the late 1970s.

But what if London itself has a housing market that never falls? We only need to go back 25 years to see that this isn’t true. According to Nationwide, a UK mortgage lender, the average London home was selling for just under £98,000 in the summer of 1989. Prices then fell by one-third and didn’t top £100,000 for nine years. Cumulative inflation over the same period was well over 50 per cent. London housing in the late 1980s was a disastrous investment.

All we have left, then, is the argument that there is something different about London’s housing market this time around, because London has become an investment hotspot for wealthy foreigners seeking a safe haven for their cash.

Surprisingly, there is truth in this story. Research by Cristian Badarinza and Tarun Ramadorai, economists at the University of Oxford, finds that trouble spots across the world are correlated with hotspots in local London property markets. When the Greek economy imploded, for example, areas of London with a higher proportion of Greek residents saw a measurable pick-up in demand. The thinking here is that if a Greek wants to get his money out of Greece and into London, he’ll pick a place where he already knows people who can scout out property and where he might someday want to live himself.

Yet the laws of supply and demand have a habit of reasserting themselves eventually. Londoners might want to glance at New York – another ludicrously expensive city, and another magnet for money and people from across the world. House prices in New York have fallen by about one-third since 2006 and are at about the same level as in the mid-1980s relative to rents, income or inflation. In the long run, why should London be any different?

The final counter-argument is the most depressing. It’s that returns on all assets will be low in future because the world has entered a secular slump. That means that house prices should be expensive because other assets are expensive too. As Oxford economist Simon Wren-Lewis points out, the secular slump theory should apply globally if it is true. And while some housing markets, including those in Australia, Canada, France and Sweden, also look expensive, others do not.

If the secular slump tale is true, London housing is sensibly priced and property in many other parts of the world has yet to catch up. Heaven help us.

“everyone knows that the UK has been building too few houses for many years”

I know this is tangential, but it’s a shame to see it thrown around so casually. There are many cheap houses in the UK, the issue is location, which really means urban design and economic (de)centralisation.

Land will rise in price to the extent that the location is desirable. It can be made desirable by being near or well-connected to another desirable place. A better way to be desirable is to be desirable by yourself. That means having a set of local policies that guide capital to build pleasant environments for humans: streets that are nice places to be in, with small shopfronts either side, or front gardens; that are scaled for enclosure and walking; that offer a range of building types.

If the UK has been building some amount of houses, but only houses, or houses on horrible car-first streets, with no neighborhood centre or high street; and in a legal/regulatory context that favours centralisation and single large business over many smaller ones (e.g. thanks to regulatory burden) – then that’s the problem, not the number of houses built.

Building more houses – just houses, not communities – and tacking them on to the edge of existing nice places, so that people can’t open a successful little business serving local needs; but have to commute. That won’t help anything.

And having now read the whole thing, it seems odd to imply there must be one explanation. Secular slump (or Kaminska’s robot surplus) plus foreign capital/surplus flows into English (ok, and French, Swedish) speaking places with good urbanism, strong property rights and stable government – that’ll do it.

Policy prescription is still: regs to incent good urbanism & political decentralisation. Take the foreign money, just make sure you build something durable, repurposable, lovable with it.

Not sure NY is a great analog (living there myself). Yes, average prices are down city wide but if you just look at Manhattan, and especially if you just look at the hyper luxury >$2000 psf market you see a very different picture. Foreign money’s not parking itself in Staten Island…

One particular line early in your piece that was glossed over (but not so easily dealt with in the real world)… “Logically, either rents should soar or prices should fall”.

The remainder of your piece (which is great by the way!) concentrates on the possibility of a price correction, but doesn’t address the equally plausible outcome that landlords will simply raise prices. There is a lot of evidence that this has been going on over much of the past decade. In the late ’90s when I lived in London, it was easy to find a 2 bed apartment in a close-in neighborhood (Camden, Islington, Shepherds Bush, Belsize Park) for around 500 a month. Nowadays you’d be hard pressed to find an apartment in an outlying suburb for 1000, with huge commuting costs to boot.

Regarding the US, yes NYC is an anomaly just like London. However, what a lot of people in the UK don’t realize is just how massive the US – there are literally a hundred cities of ~1m people where housing is dirt cheap. Outside of the big metropoli (NYC, DC, SF, LA, Boston, Atlanta, Miami, Chicago) and especially in the former rust-belt cities of the northeast, it’s easy to find a 4 bed detached house with a decent garden for <$100k. Of course, it may only be worth $110k a decade from now, so it's not really an "investment" in the same way the UK property market is. That's really the big difference – outside the hotspots, people in the US buy a house to live in, knowing it will not make them a fortune in the meantime. In the UK, people seem to buy a house purely to make money on it.

Another HUGE factor that I'd like to see you write about is the impact that the ending of the baby boom is going to have on property prices (both in the UK and globally). The thing that nobody seems to be talking about, is that we're all freaking out trying to re-tool our economies to deal with the retirement of the baby boomers. We're all ramping up healthcare and anticipating a boom in Alzheimers' and the need for managed care facilities etc. BUT, nobody's thinking about 15 years time when all these people will be dead. Right now it's all about serving the needs of the people hitting 65, but life expectancy is 75-80, so we're creating an economic bubble around this demographic. A decade from now when they're all dead, the property market is going to flooded with houses, especially in places like Florida where people go to retire. Also, a lot of these properties will be inherited by young and middle-aged folks who don't want to live where their parents lived. There are going to be a lot of properties in decaying seaside resorts in the UK going very cheap a decade from now.

While pondering if it is a bebnle or not is one thing it’s not the important thing. The important thing is the prices are far too high because the market isn’t allowed to build more. London could easily accommodate a much higher density of quality housing, well designed and avoiding the flaws of the 60s slums.

Yet we can’t do that so prices keep increasing bubble or not it still os creafing a massice drag on the economy and really serious problems for people, particularly the under 35s and essentially government support redistribution of wealth from young people to existing property owners and landlords

There’s one unexplored area in your article: the population to housing-stock ratio. It has been deteriorating, it’s a fundamental price driver and it invalidates your comparisons with Tokyo and New York.

There’s been a consistent house building shortfall in London. Prices crashed post 1989 but the population was roughly stable (6.8M, ONS Mid-year). The city started growing in 1994, price growth followed a couple years later.

“Homes for London: the draft London Housing Strategy 2013” [1] shows that New York and Tokyo are building roughly at double the rate the population growth rate (annualised over the last decade), Paris & London are the opposite, with a substantial shortfall.

Looking at the income-to-price ratio by itself is simplistic, because the demographic that owns is shifting. Owner-occupier tenure is down about 10% since its peak, while the number of cash buyers is up significantly.

Until London can outbuild the population growth by building where people want to live, the market will keep pushing out those that can’t afford it while extracting very high rents from its tenants.

Tim – I think this article suffers by omission of the efficient market theorem. As you acknowledge you provide several arguments as to why London house prices might be higher or lower in the future. We know however that ultimately in markets it is very hard to outguess the market. So there is comfort you could provide to your readers in telling them to apply EMH thinking. If you trust EMH there is no point in trying to time the market, no point in worrying if conditions will change to reduce house prices or whatever. So, if you want a house in London at a particular time in a particular area for consumption purposes, you can ditch the anxiety and buy it knowing that the price you pay will be the best estimate of the future discounted value of the housing you will need available at that time. Falls may still occur, but there should be no regrets with this philosophy.

Of course this is a treatment for consumption only. For investment purposes I would advise staying clear of taking on any more house than needed and you definitely not leverage up your entire wealth to buy the most expensive house you possibly can. Leveraged housing investment breaks two important guides in investing, firstly you should diversify for expected value purposes (or lower risk). Secondly leveraging just reduces your expected value returns (since you have to pay bank fees and interest, while the risk adjusted return without these fees remains the same). Of course leveraging is fine if you can’t get access to the money any other way to buy your house for consumption purposes, or, as sometimes happens, real interest rates are negative (as now perhaps).